1. (VI) LECTURES 18-19: EXCHANGE RATE REGIMES

2. Professor Jeffrey Frankel Topics to be covered I. Classifying countries by exchange rate regime II. Advantages of fixed rates III. Advantages of floating rates IV. Which regime dominates? ● Tests ● Optimum Currency Areas V. Additional factors for developing countries Emigrants ’ remittances Financial development Terms-of-trade shocks. VI. Intermediate regimes & the corners hypothesis Appendices

3. Continuum from flexible to rigid FLEXIBLE CORNER 1) Free float2) Managed float INTERMEDIATE REGIMES 3) Target zone/band4) Basket peg 5) Crawling peg6) Adjustable peg FIXED CORNER 7) Currency board8) Dollarization 9) Monetary union I. Classification by exchange rate regime

4. Trends in distribution of EM exchange rate regimes Ghosh, Ostry & Qureshi, 2013, “Exchange Rate Management and Crisis Susceptibility: A Reassessment,” IMF ARC, Nov.. 1973-1985 – Many abandoned fixed exchange rates 1986-94 – Exchange rate-based stabilization programs 1990s -- Corners Hypothesis: countries move to either hard peg or free float Since 2001 -- The rise of the “managed float” category. } Distribution of Exchange Rate Regimes in Emerging Markets, 1980-2011 (percent of total)

5. Many countries that say they float, in fact intervene heavily in the foreign exchange market. [1] [1] Many countries that say they fix, in fact devalue when trouble arises. [2] [2] Many countries that say they target a basket of major currencies in fact fiddle with the weights. [3][3] [1][1] “Fear of floating” -- Calvo & Reinhart (2001, 2002); Reinhart (2000). [2][2] “The mirage of fixed exchange rates” -- Obstfeld & Rogoff (1995). [3][3] Parameters kept secret -- Frankel, Schmukler & Servén ( 2000). De jure regime  de facto

6. One statistical approach to ascertain de facto regimes: Var (exchange rate) vs. Var (reserves). Calvo & Reinhart (2002) note that many countries that de jure say they float in fact have a lower Var ( Δ e) relative to Var ( Δ Res) than many that say they fix ! Levy-Yeyati & Sturzenegger (2005) classify all countries based on variability of Δ e vs. variability of Δ Res.

7. The de facto schemes do not agree. That de facto schemes to classify exchange rate regimes differ from the IMF’s previous de jure classification is by now well-known. It is less well-known that the de facto schemes also do not agree with each other !

8. Professor Jeffrey Frankel Correlations Among Regime Classification Schemes Sample: 47 countries. From Frankel, ADB, 2004. Table 3, prepared by M. Halac & S.Schmukler. GGW =Ghosh, Gulde & Wolf. LY-S = Levy-Yeyati & Sturzenegger. R-R = Reinhart & Rogoff

9. Professor Jeffrey Frankel II. Advantages of fixed rates 1)Encourage trade <= lower exchange risk. True, in theory, can hedge risk. But costs of hedging: missing markets, transactions costs, and risk premia. Empirical: Exchange rate volatility ↑ => trade ↓ ? Time-series evidence showed little effect. But more in: - Cross-section evidence, especially small & less developed countries. - Currency unions: Rose (2000).

10. The Rose finding Rose (2000) -- the boost to bilateral trade from currency unions is: – significant, – ≈ FTAs, & – larger (2- or 3-fold) than had been previously thought. Many others have advanced critiques of Rose research. – Re: sheer magnitude endogeneity, small countries, missing variables. – Estimated magnitudes are often smaller, but the basic finding has withstood perturbations and replications remarkably well. ii/ Some developing countries seeking regional integration talk of following Europe’s lead, though plans merit skepticism. [ii] E.g., Rose & van Wincoop (2001); Tenreyro & Barro (2003). Survey: Baldwin (2006)

11. Advantages of fixed rates, cont. 2) Encourage investment <= cut currency premium out of interest rates 3) Provide nominal anchor for monetary policy Barro-Gordon model of time-consistent inflation-fighting But which anchor? Exchange rate target vs. Alternatives 4) Avoid competitive depreciation (“currency wars”) 5) Avoid speculative bubbles that afflict floating. (vs. if variability is fundamental real exchange rate risk, it will just pop up in prices instead of nominal exchange rates).

12. Professor Jeffrey Frankel III. Advantages of floating rates 1. Monetary independence 2. Automatic adjustment to trade shocks 3. Retain seigniorage 4. Retain Lender of Last Resort ability 5. Avoiding crashes that hit pegged rates. (This is an advantage especially if origin of speculative attacks is multiple equilibria, not fundamentals.)

13. Monetary independence: Foreign interest rates have a negative impact on GDP in pegged countries; but flexible exchange rates do insulate according to this study. 1234 Full sampleNonpegsPegsFull sample Base i− 0.0460.046− 0.137**0.046 0.0320.0390.0440.039 Base i × Peg− 0.183** 0.055 Peg0.014** 0.004 Constant0.036**0.030**0.043**0.030** 0.0020.003 Observations3831207817533831 R20.001 0.0090.005 † or other base country ** Significant at 1%. Robust standard errors clustered at country level di Giovanni & Shambaugh (2008 ), JIE, "The impact of foreign interest rates on the economy: The role of the exchange rate regime." The effects of US † interest rate i on real output growth (Sample: 1973-2002):

14. Professor Jeffrey Frankel IV. Which dominate: advantages of fixing or advantages of floating? Performance by category is inconclusive. To over-simplify findings of 3 studies: – Ghosh, Gulde & Wolf: hard pegs work best – Sturzenegger & Levy-Yeyati: floats perform best – Reinhart-Rogoff: limited flexibility is best ! Why the different answers? – The de facto schemes do not correspond to each other. – Conditioning factors (beyond, e.g., rich vs. poor).

15. Which dominate: advantages of fixing or advantages of floating? Answer depends on circumstances, of course: No one exchange rate regime is right for all countries or all times. Traditional criteria for choosing - Optimum Currency Area. Focus is on trade and stabilization of business cycle. 1990s criteria for choosing – Focus is on financial markets and stabilization of speculation.

16. Professor Jeffrey Frankel Optimum Currency Area Theory (OCA) Broad definition: An optimum currency area is a region that should have its own currency and own monetary policy. This definition can be given more content: An OCA can be defined as: a region that is neither so small & open that it would be better off pegging its currency to a neighbor, nor so large & heterogenious that it would be better off splitting into sub-regions with different currencies.

17. Professor Jeffrey Frankel Optimum Currency Area criteria for giving up currency independence: Small size and openness – because then advantages of fixing are large. Symmetry of shocks – because then giving up monetary independence is a small loss. Labor mobility – because then it is possible to adjust to shocks even without ability to expand money, cut interest rates or devalue. Fiscal transfers in a federal system – because then consumption is cushioned in a downturn.

18. Professor Jeffrey Frankel The endogeneity of the OCA criteria Endogeneity of OCA criteria: Bilateral trade responds positively to currency union -- Rose (2000). A country pair’s cyclical correlation rises too (rather than falling, as under Eichengreen-Krugman hypothesis). Implication:members of a monetary union may meet OCA criteria better ex post than ex ante -- Frankel & Rose (1996).

19. Popularity in 1990s of institutionally-fixed corner currency boards (e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina, 1991-2001; Bulgaria, 1997- ; Estonia 1992-2011; Bosnia, 1998- ; …) dollarization ( e.g, Panama, El Salvador, Ecuador) monetary union ( e.g., EMU, 1999)

20. 1990’s criteria for the firm-fix corner suiting candidates for currency boards or union (e.g. Calvo) Regarding credibility: Regarding other “initial conditions”: an already-high level of private dollarization high pass-through to import prices access to an adequate level of reserves the rule of law. a desperate need to import monetary stability, due to: – history of hyperinflation, – absence of credible public institutions, – location in a dangerous neighborhood, or – large exposure to nervous international investors a desire for close integration with a particular neighbor or trading partner

21. V. Three additional considerations, particularly relevant to developing countries (i) Emigrants’ remittances (ii) Level of financial development (iii) Supply shocks and external terms of trade shocks

22. I would like to add to the traditional OCA list: (i) Cyclically-stabilizing emigrants’ remittances. If country S has sent immigrants to country H, are their remittances correlated with the differential in growth or employment in S versus H? Apparently yes. (Frankel, “Are Bilateral Remittances Countercyclical?” 2011 ) This strengthens the case for S pegging to H. Why? It helps stabilize the current account even when S has given up ability to devalue.

23. (ii) Level of financial development Aghion, Bacchetta, Ranciere & Rogoff (2005) – Fixed rates are better for countries at low levels of financial development: markets are thin. – When financial markets develop, exchange flexibility becomes more attractive. Estimated threshold: Private Credit/GDP > 40%. Husain, Mody & Rogoff (2005) For richer & more financially developed countries, flexible rates work better – in the sense of being more durable – & delivering higher growth without inflation.

24. (iii) External Shocks An old wisdom regarding the source of shocks: – Fixed rates work best if shocks are mostly internal demand shocks -- especially monetary; – floating rates work best if shocks tend to be real shocks -- especially external terms of trade.

25. Terms-of-trade variability Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008 & 2011. => Favorable terms of trade shocks for some (oil producers, such as Mideast, Africa, Latin America); => Unfavorable terms of trade shock for others (oil importers such as India, Korea, Turkey). Textbook theory says a country where trade shocks dominate should accommodate by floating. Confirmed empirically: – Developing countries facing terms of trade shocks do better with flexible exchange rates than fixed exchange rates. – Broda (2004 ), Edwards & L.Yeyati (2005), Rafiq (2011), and Céspedes & Velasco (2012)

26. 26 Constant term not reported. (t-statistics in parentheses.) ** Statistically significant at 5% level. Across 107 major commodity boom-bust cycles, output loss is bigger the bigger is the commodity price change & the smaller is exchange rate flexibility. Céspedes & Velasco, 2012, IMF Economic Review “Macroeconomic Performance During Commodity Price Booms & Busts”

27. VI. Intermediate exchange rate regimes and the corners hypothesis

28. Intermediate regimes target zone (band) Krugman-ERM type (with nominal anchor) Bergsten-Williamson type (FEER adjusted automatically) basket peg (weights can be either transparent or secret) crawling peg pre-announced (e.g., tablita) indexed (to fix real exchange rate) adjustable peg (escape clause, e.g., contingent on terms of trade or reserve loss) Managed float (leaning against the wind)

29. Origins: 1992-93 ERM crises -- Eichengreen (1994) Late-90’s crises in emerging markets – Fischer (2001). But the pendulum swung back, from 61% of IMF staff in 2002, to 0% in 2010. Many developing countries follow intermediate exchange rate regimes. The theoretical rationale for the corners hypothesis never was clear. The Corners Hypothesis The hypothesis: “Countries are, or should be, abandoning intermediate regimes like target zones and moving to either one corner or the other: rigid peg or free float.

30. Managed float (“leaning against the wind”): Kaushik Basu & Aristomene Varoudakis, Policy RWP 6469, World Bank, 2013, “How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better” May, p. 14 Turkey’s central bank buys lira when it depreciates, and sells when it is appreciates.

31. In Latin America, renewed inflows in 2010 less-managed floating (“more appreciation-friendly”) more-managed floating Source: GS Global ECS Research but as appreciation in Chile & Colombia. were reflected mostly as reserve accumulation in Peru,

32. Korea & Singapore in 2010 took renewed inflows mostly in the form of reserves, Goldman Sachs Global ECS Research less-managed floating (“more appreciation-friendly”) more-managed floating while India & Malaysia took them mostly in the form of currency appreciation.

33. The flexibility parameter can be estimated in terms of Exchange Market Pressure: – Define Δ EMP = Δ value of currency + Δ reserves/MB. – Δ EMP represents shocks in currency demand. – Flexibility can be estimated as the propensity of the central bank to let shocks show up in the price of the currency (floating), vs. the quantity of the currency (fixed), or in between (intermediate exchange rate regime).

34. Distillation of technique to infer flexibility When a shock raises international demand for the currency, does it show up as an appreciation, or as a rise in reserves? EMP variable appears on the RHS of the equation. The % rise in the value of the currency appears on the left. – A coefficient of 0 on EMP signifies a fixed E (no changes in the value of the currency), – a coefficient of 1 signifies a freely floating rate (no changes in reserves) and – a coefficient somewhere in between indicates a correspondingly flexible/stable intermediate regime.

35. APPENDICES ON EXCHANGE RATE REGIMES Appendix 1: Tables comparing economic performance of different regimes Appendix 2: The econometrics of estimating de facto exchange rate regimes. Appendix 3: IT versus alternative anchors, with volatility in commodity export prices

36. Appendix 1 Tables comparing economic performance of different regimes: – Ghosh, Gulde & Wolf – Sturzenegger & Levy-Yeyati – Reinhart & Rogoff

37. Which category experienced the most rapid growth? Levy-Yeyati & Sturzenegger: floating Reinhart & Rogoff: limited flexibility Ghosh, Gulde & Wolf: currency boards

39. Levy-Yeyati & Sturzenegger (2001): floats work best.

40. Levy-Yeyati & Sturzenegger (2001). Sample: yearly observations 1974-1999. Effect of regime on growth rates, controlling for various determinants

41. Appendix 2: The econometrics of estimating de facto exchange rate regimes. Why do the various schemes for classifying countries by de facto exchange rate regimes give such different answers? Synthesis of the technique for estimating the anchor and the technique for estimating the degree of exchange rate flexibility.

42. Schemes for de facto classification have themselves been divided into two classifications, viewed as: – “mixed de jure-de facto classifications, because the self-declared regimes are adjusted by the devisers for anomalies. ” – Vs. “pure de facto classifications because…assignment of regimes is based solely on statistical algorithms….” -- Tavlas, Dellas & Stockman (2006).

43. Professor Jeffrey Frankel Jay Shambaugh (2007) again finds that the de facto classification schemes tend to agree with each other even less than they agree with the de jure scheme.

44. -- but still close to official IMF one: correlation (BOR, IMF) =.76 The IMF now has its own “de facto classification” As do Bénassy-Quéré et al (2004)

45. Pure de facto classification schemes 1.Method to estimate degree of flexibility: Levy-Yeyati & Sturzenegger (2005): compare variability of Δ exchange rates vs. variability of Δ reserves. 2. Method to estimate implicit basket weights: Regress Δ value of local currency against Δ values of major currencies. Frankel & Wei (1993, 95, 2007), Bénassy-Quéré (1999), B-Q et al (2004). Close fit => a peg. Coefficient of 1 on $ => $ peg. Or on other currencies => basket peg. Example of China, post 7/2005. 3. Synthesis method: F & Wei (2008), F & Xie (2010). Regress Δ value of local currency against EMP, to estimate flexibility parameter and against Δ values of $ and other major currencies, to estimate weights in anchor basket.

46. Appendix 3 IT versus alternative anchor (PEP) to take into account commodity export prices

47. Professor Jeffrey Frankel Fashions in international currency policy 1980-82: Monetarism (target the money supply) 1984-1997: Fixed exchange rates (incl. currency boards) 1993-2001: The corners hypothesis 1998-2008: Inflation targeting (+ currency float) became the new conventional wisdom Among academic economists among central bankers and at the IMF

48. Professor Jeffrey Frankel 6 proposed nominal targets and the Achilles heel of each:

49. Professor Jeffrey Frankel Inflation Targeting has been the reigning orthodoxy. Flexible inflation targeting ≡ “Have a LR target for inflation, and be transparent.” Who could disagree? But define IT as setting yearly CPI targets, to the exclusion of asset prices exchange rates export commodity prices. Some reexamination is warranted, in light of 2008-2011.

50. Professor Jeffrey Frankel The shocks of 2008-2015 showed disadvantages to Inflation Targeting, The shocks of 2008-2015 showed disadvantages to Inflation Targeting, – analogously to how the EM crises of the 1994-2001 showed disadvantages of exchange rate targeting. It gives the wrong answer in case of trade shocks: It gives the wrong answer in case of trade shocks: E.g., it says to tighten money & appreciate in response to a rise in oil import prices; It does not allow monetary tightening & appreciation in response to a rise in world prices of export commodities. That is backwards.

51. Proposal to Peg the Export Price Intended for countries with volatile terms of trade, e.g., those specialized in commodities. The authorities stabilize the currency in terms of a basket of currencies plus the price of the export commodity rather than to the CPI (which gives weight to imports) and rather than a simple fixed exchange rate. The regime combines the best of both worlds: (i)The advantage of automatic accommodation to terms of trade shocks, together with (ii)the advantages of a nominal anchor. PEP

52. Professor Jeffrey Frankel Why is PEP better than targeting the exchange rate or CPI for countries with volatile terms of trade ? Better response to adverse terms of trade shocks: If the $ price of the export commodity goes up, PEP says to tighten monetary policy enough to appreciate currency. – Right response. (E.g., Gulf currencies in 2007-08.) If the $ price of imported commodity goes up, CPI target says to tighten monetary policy enough to appreciate currency. – Wrong response. (E.g., ECB or other oil-importers in 2007-08.) – => CPI targeting gets it backwards. PEP

53. Professor Jeffrey Frankel Does floating give the same answer as PEP? True, commodity currencies tend to appreciate when commodity markets are strong, & vice versa – Australian, Canadian & NZ $ (e.g., Chen & Rogoff, 2003) – South African rand (e.g., Frankel, 2007) – Chilean peso and others But – Some volatility under floating appears gratuitous. – Floaters still need a nominal anchor.

54. Professor Jeffrey Frankel The Rand, 1984-2006: Fundamentals (real commodity prices, real interest differential, country risk premium, & l.e.v.) can explain the real appreciation of 2003-06 – Frankel (SAJE, 2007). Actual vs Fitted vs. Fundamentals- Projected Values

55. In practice, most IT proponents agree central banks should not tighten to offset oil price shocks They want focus on core CPI, excluding food & energy. But – food & energy ≠ all supply shocks. – Use of core CPI sacrifices some credibility: If core CPI is the explicit goal ex ante, the public feels confused. If it is an excuse for missing targets ex post, the public feels tricked. – The threat to credibility is especially strong where there are historical grounds for believing that government officials fiddle with the CPI for political purposes. – Perhaps for that reason, IT central banks apparently do respond to oil shocks by tightening/appreciating ….